European Banks Risk New Global Financial Crisis, IMF Warns

European banks risk creating a new global financial crisis as they shrink their balance sheets by more than $2 trillion through the end of next year, the International Monetary Fund said Wednesday.

Without careful oversight by euro-zone authorities, the potential consequences of a synchronized and large-scale reduction in banks’ portfolios could cause “serious damage to asset prices, credit supply and economic activity in Europe and beyond,” the IMF said in a new report.

The fund outlined a raft of policies it said are necessary to avoid a worst-case scenario, including furthering central-bank support, expanding the use of the region’s emergency funds to invest in banks as a way to inject needed capital and soften the impact of banks unwinding their risky assets, and accelerating financial-sector reforms.

Without action, the fund said Europe risks forcing an international fire-sale of bank assets, with banks rapidly shrinking their portfolios by an estimated $3.8 trillion. Besides a credit crunch and a resurgence of default risk in the euro zone, that would likely spark a chain reaction across the globe. Emerging markets would be whip-sawed as capital flooded out of their economies. The U.S. derivatives markets could likely face another meltdown. And near-term prospects for a global economic recovery would be shattered.

“Through derivative markets, stress could be transmitted to U.S. banks, even though their direct exposures to European banks and sovereigns are relatively low,” the fund said.

Jose Vinals, director of the fund’s capital markets group, told reporters at a press conference that the onus is on European authorities to take the necessary steps to contain the crisis. He downplayed the idea that the European Central Bank should go much further beyond its current accommodative stance.

“The focus should be put not on what else can the ECB do. The ECB has bought very precious time that now the political authorities need to use to do the other things which are needed,” Vinals said.

The IMF based its latest Global Financial Stability Report on an analysis of 58 of the euro zone’s largest banks, including Deutsche Bank, Banco Santander SA and BNP Paribas. The report will help set the stage for discussions among finance ministers and central bankers at the spring meetings of the IMF and Group of 20 largest industrialized and developing economies that begin later this week.

Europe’s crisis will be at the center of the talks. Despite raising its global growth outlook for the year, the IMF warned that Europe’s crisis is at a decisive stage that could help cultivate a worldwide recovery or spiral out of control and dissolve the euro zone.

The IMF said the nearly five-dozen banks it studied have already made public plans for roughly $2 trillion in portfolio reductions through 2013. In the last quarter of the year, the fund estimates banks had already cut $580 billion off their balance sheets. That contributed to a tightening of credit, which then prompted the European Central Bank to issue cheap loans to avoid a freezing of lending.

But the IMF expects the actual number for the portfolio reduction is closer to $2.6 trillion, roughly 7% of total assets and a much larger amount than implied by the capital plans submitted to the European Banking Authority.

Banks need to deflate their portfolios for a number of reasons. Many still have too many risky assets and too few capital buffers to cover potential losses. The deleveraging comes as banks are trying to cope with exposures to weak economies, anemic growth and high refinancing requirements.

“Although some deleveraging is both inevitable and desirable, its precise impact depends on the nature, pace and scale of the asset-shedding,” the IMF said.

In the near term, the IMF said more ECB action than the central bank has said it wants–including lower interest rates and more cheap loans–is likely warranted. It is urging euro-zone leaders to speed up bank restructuring and new rules for winding down failed banks. Also, the fund said Europe should be prepared to back bank write-downs of bad debt with its emergency bailout funds and inject capital directly into banks. To this end, Europe’s recent expansion of its firewall capacity was “an important first step,” the fund said.

But the European Union also needs to begin developing credible plans for greater economic unity and sharing risks between members, the IMF said. It recommends euro-zone bonds or bills, a plan that has so far gained little traction in regional economic and political powerhouse Germany.

The IMF said most emerging markets could withstand a moderate shrinkage of bank balance sheets. But, the fund cautioned, “their resilience could be tested in a downside scenario, notably in emerging Europe.”

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